Those on the wrong end of the coming crash are going to be absolutely wiped out.

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Most Americans do not understand what “derivatives” are, so they kind of tune out when people start talking about them. But they are very important to understand. Essentially, derivatives are “side bets”. When you buy a derivative, you are not investing in anything. You are just gambling that something will or will not happen. I explained this more completely in a previous article entitled “The Coming Derivatives Crisis That Could Destroy The Entire Global Financial System“….

A derivative has no underlying value of its own. A derivative is essentially a side bet. Usually these side bets are highly leveraged. At this point, making side bets has totally gotten out of control in the financial world. Side bets are being made on just about anything you can possibly imagine, and the major Wall Street banks are making a ton of money from it. This system is almost entirely unregulated and it is totally dominated by the big international banks. Over the past couple of decades, the derivatives market has multiplied in size. Everything is going to be fine as long as the system stays in balance. But once it gets out of balance we could witness a string of financial crashes that no government on earth will be able to fix.

Five very large U.S. banks (including Goldman Sachs, JP Morgan and Bank of America) have combined exposure to derivatives in excess of 250 trillion dollars. Keep in mind that U.S. GDP for 2011 was only about 15 trillion dollars. So we are talking about an amount of money that is almost inconceivable. That is why I cannot talk about derivatives enough. In fact, I apologize to my readers for not writing about them more. If you want to understand the coming financial collapse, one of the keys is to understand derivatives. Our entire financial system has been transformed into a giant casino, and at some point all of this gambling is going to cause a horrible crash.

The JP Morgan (JPM) trading blunder could result in a $100 billion loss, a contagion of its massive portfolio, and even the wipeout of its entire asset base. Even worse, these extremely risky and potentially-illegal actions on behalf of the CIO office and the “London Whale” could be the unexpected “shock” that breaks the market, derails the Fed’s huge monetary stimulus, and sends us back into a global recession.

The JP Morgan Shock

The entire world has forgotten about or ignored what could be the upcoming “shock” that puts the global financial system in severe jeopardy. To make matters much, much worse – I don’t think anyone even has a clue as to what is really happening. Investors, economists, financial powerhouses, top business executives, politicians, lawmakers, consumers, students, governments, and even central banks are completely confused. None of them are expecting what I will describe below.

There is one event that may ultimately solve the mystery of the global economy. This event would not only plunge the economy back into a deep recession and lose investors hundreds of billions of dollars, but it could bring about the collapse of some of the world’s largest financial institutions and even render central bank stimulus and QE completely ineffective and futile. This event is by no means a guarantee; its probability is even likely under 5 percent. But this event has all the necessary ingredients to culminate into a major panic. Together with slowing global economies and an extremely unstable financial system, this could be the next Lehman Brothers.

This event is JP Morgan’s huge trading mistake. The massive losses that were racked up starting in April and May 2012 are by no means over. What has been represented by JP Morgan as a trading mistake and “hedging” strategy with an initial estimated loss of $2 billion, was really a leveraged and speculative bet that could soon infect JP Morgan’s entire portfolio and result in losses of $100 billion.

The most famous financial tsunami in modern history occurred in 1929-32. Almost no one saw it coming.

If you’re a passenger aboard a ship in deep water, you can’t detect a tsunami; the swells are indistinguishable from regular ocean waves. Wave lengths can be hundreds of miles long, but only when this energy reaches shallow water does the mammoth tsunami wall form — and can wash over anything in its path.

So when forecasters warn “Move to higher ground!” it’s not wise to think, “Until I see the tsunami, I won’t believe it’s coming.” Once it’s visible, it’s probably too late.

It’s equally unwise to ignore signs of a financial tsunami.

Investors who wait … before acting will be too late. We have to anticipate developments, and the only way we can do that is to use tools that reveal signs of approaching trend change.

The Elliott Wave Theorist, March 2012

The most famous financial tsunami in modern history occurred in 1929-32. Almost no one saw it coming. For example, the observation below was made shortly before the 1929 Crash.

The problem with derivatives is that they often involve highly leveraged bets, when everyone starting to demand collaterals, everything is will collapse just like 2008.

The Lehman episode was only one example of the shortcomings in the $19tn over-the-counter derivatives market exposed by the financial crisis. In the boom years, the opaque nature of the market allowed large concentrations of risk to grow, out of sight of regulators. This happened above all at the insurer AIG.

When the crisis broke, the same opacity made it impossible for market participants to assess the true health of other financial firms. There were strong incentives for counterparties to demand more collateral or to move their trades at the first sign of trouble. This process drained liquidity from stressed businesses in a modern-day version of an old-fashioned bank run.

J.P. Morgan’s exposure to the stressed European countries nearly doubled in the third quarter, as CEO Jamie Dimon said the region is making progress.

The bank’s next exposure to the five peripheral economies approached $12 billion in the third quarter, up from $6.2 billion in the second quarter, though it’s still below the $12.5 billion it had in the first quarter.

As of the end of September, J.P. Morgan had $4.7 billion net total exposure to Spain and $5.9 billion in exposure to Italy. Exposure to Greece, Ireland and Portugal stood at $1.1 billion combined, in the third quarter.

The BU School of Management’s Mark T. Williams calls it “hedge-u-lation”—speculative binges like those that earned global banking giant JPMorgan Chase worldwide headlines after its bet on a European recovery ate $5.8 billion… and counting. The magnitude of the losses has experts and consumers scratching their heads and renewing calls for banking reform legislation.

After taking its hardest weekly hit in four months, the U.S. stock market next week confronts third-quarter earnings in earnest, with 40% of the Dow components reporting.

“Earnings will dominate next week’s news flow. More importantly, we get management’s color on how the balance of the year looks,” said Lawrence Creatura, portfolio manager at Federated Investors Inc.

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“Basically the news hadn’t been good, but the market went up regardless. This week, we gave a little of it back. Ironically, it was in the face of some quite positive data, conspicuously positive data on the employment front,” Creatura added about the jobless rate falling to 7.8% in September.

Third-quarter U.S. earnings have just begun, but already U.S. companies are sounding alarm bells about the fourth quarter.

Outlooks for the fourth quarter – just two weeks old – are so far decidedly more negative than positive. Thomson Reuters data shows 11 negative outlooks so far from Standard & Poor’s 500 companies and no positive outlooks.

Third-quarter guidance, meanwhile, at the comparable period showed 6 negative outlooks and no positive.

The market has seen this play out before – companies systematically lower the bar, only to exceed estimates by a fair amount, resulting in “surprises” that bolster stock prices. This hasn’t happened yet in this earnings season, but investors are on the lookout for it.